It's important to understand the differences between variable interest rates and fixed interest rates if you're considering a loan. Whether you're applying for a new mortgage, refinancing your current mortgage, or applying for a personal loan or credit card, understanding the differences between variable and fixed interest rates can help save you money and meet your financial goals.
Key Takeaways
- A variable interest rate loan is a loan where the interest charged on the outstanding balance fluctuates based on an underlying benchmark or index that periodically changes.
- A fixed interest rate loan is a loan where the interest rate on the loan remains the same for the life of the loan.
- A variable rate loan benefits borrowers in a declining interest rate market because their loan payments will decrease as well.
- However, when interest rates rise, borrowers who hold a variable rate loan will find the amount due on their loan payments also increases.
- A popular type of variable rate loan is a 5/1 adjustable-rate mortgage (ARM), which maintains a fixed interest rate for the first five years of the loan and then adjusts the interest rate after the five years are up.
Variable Interest Rate Loans
A variable interest rate loan is a loan in which the interest ratecharged on the outstanding balance varies as market interest rates change. The interest charged on a variable interest rate loan is linked to an underlying benchmark or index, such as the federal funds rate.
As a result, your payments will vary as well (as long as your payments are blended withprincipalandinterest). You can find variable interest rates in mortgages, credit cards, personal loans, derivatives, and corporate bonds.
Variable Rate Loans
Pros
Loan repayments decrease when interest rates fall.
Loans typically get better upfront perks like low introductory rates for an initial loan period.
The interest rate for a variable loan is generally lower than a fixed loan, especially when the loan is incurred.
Cons
Loan repayments increase when interest rates rise.
Loans may become more expensive than fixed rate loans should interest rates rise quickly.
Borrowers face greater risk if overcapitalized or already at repayment capacity.
Borrowers may not be able to plan or forecast future cashflow due to changing rates.
Fixed Interest Rate Loans
Fixed interest rate loans are loans in which the interest rate charged on the loan will remain fixed for that loan's entire term, no matter what market interest rates do. This will result in your payments being the same over the entire term. Whether a fixed-rate loan is better for you will depend on the interest rate environment when the loan is taken out and on the duration of the loan.
When a loan is fixed for its entire term, it remains at the then-prevailing market interest rate, plus or minus aspreadthat is unique to the borrower. Generally speaking, if interest rates are relatively low, but are about to increase, then it will be better to lock in your loan at that fixed rate.
Depending on the terms of your agreement, yourinterest rateon the new loan will stay the same, even if interest rates climb to higher levels. On the other hand, if interest rates are on the decline, then it would be better to have a variable rate loan. As interest rates fall, so will the interest rate on your loan.
Fixed Rate Loans
Pros
Borrowers know exactly what their monthly payment will be regardless of market rate changes.
Fixed rates do not rise during periods of rising interest rates.
Borrowers can self-select their own time frames for many loans ranging from 6-month to 10-year non-mortgage loans.
Cons
Loans are less flexible under fixed rate agreement terms.
Fixed rates do not fall during periods of declining interest rates.
Fixed term fees may incur additional fees should the borrower want to change terms or exit the loan early.
Fixed rate loans have historically been more expensive over their life than variable rates.
Which Is Better: Fixed Interest Rate or Variable Rate Loan?
This discussion is simplistic, but the explanation will not change in a more complicated situation. Studies have found that over time, the borrower is likely topay less interest overall with a variable rate loanversus a fixed-rate loan.
However, historical trends aren't necessarily indicative of future performance. The borrower must also consider theamortization periodof a loan. The longer the amortization period of a loan, the greater the impact a change in interest rates will have on your payments.
The determination of whether a fixed or variable rate loan is better depends on the borrower's financial profile and preferences. Begin by assessing your cash flow, financial flexibility, and need for security. Not every person will be in the same situation, and the variety of financial loan products can cater to whatever is best for the borrower.
There are other factors to consider when deciding on the type of rate to pursue:
- Interest Rate Trends and Forecast: In general, if you think interest rates are going up, locking into a fixed rate agreement is favorable (at least in the short term). If you think interest rates are going down, a variable rate agreement is ideal in the short term.
- Interest Rate Spread: Sometimes, you may want one type of loan, but it's so much more expensive than the other. Always look at the terms for both; though you may be inclined to only pursue one, the difference between the terms for a fixed loan versus a variable loan may sway you one way over the other.
- Loan Term: Though nobody knows what long-term economic conditions entail, you may base your decision on short-term conditions if you do not expect to have the debt for a long period. Though this concept of fixed and variable rates is integral to buying a home, these terms are also available on much shorter debt.
- Anticipated Personal Income Forecast: The decision around fixed or variable rates centers around the need for security. Evaluate your personal income situation including job stability, prospective salary growth, and current savings. If you project higher income in the future, the risk of variable rates decreases as you anticipate having more disposable income to counter rising expenses.
Split Rate Loans
A split rate loan allows borrowers to split their loan amount between fixed and variable interest rate components. These are also known as hybrid ARM loans. Regardless of prevailing economic situations, your loan will have missed many benefits of each type of loan but will have mitigated rate risk.
Adjustable-Rate Mortgages
Adjustable-rate mortgages(ARM) are beneficial for a borrower in a decreasing interest rate environment, but when interest rates rise, thenmortgagepayments will rise sharply. The most popular ARM loan product is the 5/1 ARM, in which the rate remains fixed, usually at a rate lower than the typical market rate, for five years.
After the five years is up, the rate begins adjusting and will adjust each year. Use a tool likeInvestopedia's mortgage calculatorto estimate how your total mortgage payments can differ depending on which mortgage type you choose.
An ARM might be a good fit for a borrower who plans to sell their home after a few years or one who plans to refinance in the short term. The longer you plan to have the mortgage, the riskier an ARM will be.
While initial interest rates on an ARM may be low, once they begin to adjust, the rates will typically be higher than those on a fixed-rate loan. During the subprime mortgage crisis, many borrowers found that their monthly mortgage payments had become unmanageable once their rates started to adjust.
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Is a Variable or Fixed Rate Better?
In a period of decreasing interest rates, a variable rate is better. However, the trade off is there's a risk of eventual higher interest assessments at elevated rates should market conditions shift to rising interest rates.
Alternatively, if the primary objective of a borrower is to mitigate risk, a fixed rate is better. Although the debt may be more expensive, the borrower will know exactly what their assessments and repayment schedule will look like and cost.
Is a Variable or Fixed Rate Lower?
Macroeconomic conditions often dictate whether a variable rate or fixed rate is lower. In general, the Federal Reserve often lowers interest rates to encourage business activity during periods of economic stagnation or recession. Then, instead of prioritizing unemployment, the Federal Reserve will increase interest rates to slow the economy to combat inflation.
What Is the Danger of Taking a Variable Rate Loan?
Your lender can change your interest rate at any time. While this does present opportunities for lower interest rates, you may also be assessed interest at higher rates that are increasingly growing. There is no way of knowing what your future interest rate assessments will be under a variable rate contract. Therefore, you may end up with insufficient cash flow to pay down monthly payments as those payments may increase in the future.
Do Variable Rates Ever Go Down?
Yes, variable interest rates can fall as well as rise. Interest rates are more likely to decline during periods of slower economic activity. To encourage business development and job creation, the Federal Reserve will often lower rates, which drive lower borrowing costs for loans on a variable rate.
Can I Switch from a Variable Rate to Fixed Rate?
Yes, lenders often allow borrowers to convert from a variable rate to a fixed rate. There are usually fees associated with converting the loan terms. It's less common to see contracts change from a fixed-rate agreement to a variable rate agreement.
The Bottom Line
One type of interest rate doesn't work best for everyone. Some borrowers may prefer having a variable interest rate that could drop in the future. Others may prefer knowing their fixed interest rate will result in a consistent amortization schedule of payments. Be mindful of the risks and downsides as you consider whether to make the rate on your next loan a fixed or variable interest rate.
